Hanger Orthopedic Group, Inc. ( HGR)

Q3 2010 Earnings Conference Call

October 28, 2010 9 AM ET

Executives

Tom Kirk – President and CEO

Tom Hofmeister – Chief Accounting Officer and VP - Finance

George McHenry – EVP and CFO

Analysts

David MacDonald – SunTrust

Larry Solow – CJS Securities

Bryan Sekino – Barclays Capital

Michael Petusky – Noble Research

Dawn Brock – Kaufman Brothers

Todd Morgan – Oppenheimer & Co.

Presentation

Operator

Good morning. My name is Kyle and I will be your conference operator today. At this time I would like to welcome everyone to the Hanger Orthopedic Group’s Q3 results conference call. (Operator Instructions). Thank you. Mr. Kirk, you may begin your conference.

Tom Kirk

Thank you, Kyle. Good morning to everyone and welcome to Hanger Orthopedic Group’s discussion of our Q3 results. Before starting the discussion let me ask Tom Hofmeister, our Chief Accounting Officer and Director of IR, to review with you our declaration on forward-looking statements. Tom?

Tom Hofmeister

Good morning. During this call management will make forward-looking statements related to the company’s results of operations. The United States Private Securities Litigation Reform Act of 1995 provides a safe harbor for certain forward-looking statements. Statements relating to future results of operations in this document reflects the views of management. However, various risks, uncertainties and contingencies could cause actual results or performance to differ materially from those expressed in or implied by these statements. These include the company’s ability to enter into and derive benefits from managed care contracts, the demands for the company’s orthotic and prosthetic services and products, and other factors identified in the company’s period reports on Form 10K and Form 10Q filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934. The company disclaims any intent or obligation to publicly update these forward-looking statements, whether as a result of new information, future events, or otherwise.

Tom Kirk

Thank you, Tom. In addition to Tom Hofmeister, I’m also joined this morning with George McHenry, our EVP and Chief Financial Officer. If we step back from the quarter on an overall basis I think there’s several noteworthy points. We grew our consolidated sales by 7.5% over the Q3 of last year. This sales performance combined with cost management yielded $0.37 earnings per share, excluding the costs associated with our relocation of our corporate office here to Austin and the costs associated with the diligence efforts surrounding Accelerated Care Plus. Now this earnings per share equates to a 23.3% growth over last year’s Q3, and this makes the 19 th consecutive quarter where we have met or exceeded first call estimates.

In addition, I just want to note that we’ve completed our corporate office relocation to Austin on time and within budget, and we recently announced the signing of a definitive agreement to purchase Accelerated Care Plus. It certainly has been a busy quarter. Now let me turn this over to George who will review our financial results and balance sheet changes in detail.

George McHenry

Thank you, Tom. Good morning, everyone, and thank you for joining us. Q3 was really an outstanding quarter for the company. The important takeaways are as follows. Our adjusted EPS as Tom mentioned of $0.37 represented 23.3% growth over the prior year, exceeding street estimates. Our track record of consistent performance now dates back almost five years. We increased operating leverage excluding relocation expense by 60 basis points through a combination of healthy sales growth and control of spending.

We experienced accelerated growth through all lines of our business. Our sales growth accelerated overall to 7.5% from 6.4% in Q2 and 5.4% in Q1. Com sales and the patient care segment accelerated to a 4.1% increase, which was an improvement over 4% in Q2 and 3.6% in Q1, and our distribution segment reported a healthy 10.5% increase compared to 10.4% in Q2. So they’re doing very well. Our com rate of 30.7% is comparable to the prior year but slightly higher than the rate we expect for the full year.

We continue to do an excellent job managing expenses. Personnel costs were below budget amounts and generated a considerable amount of operating leverage. Operating expenses were below budget overall and also contributed to EBIDTA margin improvements. As I mentioned last quarter, our employees have to be commended for their efforts in this area because they really make this work.

We moved into our new headquarters as Tom mentioned on schedule on August 16 th. In this quarter we recorded $8 million in costs. The largest single charge included in this number was a $5 million reserve for rent related to the abandonment of our old headquarters in Bethesda, Maryland. These expenses are non-recurring and are shown as a separate line item on our income statement. D&A increased by $0.5 million compared to 2009, which is commensurate with the run rate of capital expenditures over the last 12 months.

All these factors I just discussed led to the 23.3% increase in adjusted EPS for the quarter. Moving on to the nine months, overall performance for the first nine months was in line with our expectations in terms of sales and exceeded our expectations from an earnings perspective. Operating leverage has improved by 50 basis points which exceeds our goal of 20-40 basis points. Revenue growth improved to 6.5%, in the middle of our expected range, with HPO same center sales increasing by 4% and our distribution business increasing 8.5%. Our com rate of 30.4% was equal to last year and is in line with our internal expectations.

Excluding relocation costs, income from operations increased to 11.9%, a 50 basis point improvement. Year to date we have incurred $14.2 million of relocation costs which is in line with our internal projections and guidance to the street. D&A was $1 million higher than last year due to higher capital additions and our tax rate to date is approximately 37.3%. Some of that rate decrease was due to a FIN 48 release in Q2. Our rate for the full year should approximate 48%. Adjusted diluted EPS was $0.90 or an 18.4% increase over the prior year.

Moving on to the balance sheet and the cash flow, our AR balance was $104.6 million. We continue to do a commendable job collecting our cash. DSOs were 47 days, which is in the low end of the range we expect. We are comfortable with our reserve for doubtful accounts and our bad debt expense remains low at approximately 2%. Inventory increased by $7.3 million to $98.6 million from $91.3 million at the end of last year. Inventory turns were four times. Our sales backlog remained strong at quarter end and we believe that our inventory is at an appropriate level to serve our patients.

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